Tesla Surprises With Profitable Q3 on Great Model 3 Margins

Eric Wesoff is Editor-at-Large at Greentech Media. Prior to joining GTM, Eric Wesoff founded Sage Marketing Partners in 2000 to provide sales and marketing-consulting services to venture-capital firms and their portfolio companies in the alternative energy and telecommunications sectors. Mr. Wesoff has become a well-known, respected authority and speaker in these fields.

His expertise covers solar power, fuel cells, biofuels and advanced batteries. His strengths are in market research and analysis, business development and due diligence for investors. He frequently consults for energy startups and Silicon Valley's premier venture capitalists.

Financial highlights for the quarter

Here are some strong numbers from the world's most disruptive automotive upstart:

GAAP net income of $312 million on revenue of $6 billion

Automotive revenue grew 82 percent over Q2, due to the growth of Model 3 deliveries

Free cash flow of $881 million

$3.0 billion of cash and cash equivalents at quarter's end

Model 3 gross margin of better than 20 percent

Tesla guides for continued GAAP net income and free cash flow in Q4

Q3 operational highlights

Musk has at various times promised production rates of up to 10,000 units per week. And Tesla has said that it cannot be profitable on a $35,000 Model 3 without consistent 5,000-unit production weeks.

While that 10,000 number is a bit of a stretch, Model 3 production averaged approximately 4,300 units per week, and the firm was able to push production to 5,300 Model 3s in the final week of the third quarter. So, the threshold of profitable production appears to be at hand.

Tesla opened four new store and service sites in the quarter, for a total of 351 locations worldwide. It also plans to open up dozens of its own body shops in the U.S. over the next few quarters.

Model 3: "A truly mainstream product"

Today's investor letter boasted of the Model 3's status as the bestselling car in the U.S. in terms of revenue and the fifth-bestselling car in terms of volume.

CEO Elon Musk called the Model 3 "a truly mainstream product."

Musk said the Model 3 production system "stabilized" in the third quarter as the company went from "a steep S-curve to more gradual monthly improvements." These changes enabled production of an all-wheel drive version of the Model 3 (a more complex car to build), while labor hours per unit decreased by more than 30 percent from the previous quarter — clocking in below the labor hours for Models S and X for the first time.

Automotive gross margin across all models jumped to almost 26 percent from 20.6 percent in the previous quarter.

Delivery and logistics

The investor letter singled out delivery and logistics as the company's chief challenges in Q3 as its delivery system goes through a ramp akin to what its production system went through last quarter.

Tesla views these challenges as "easier to solve than vehicle manufacturing" and looks to expand and improve its direct-to-customer program, claiming, "delivering vehicles to the front door of a customer’s house or office is superior from both a cost and customer satisfaction perspective."

Tesla's vehicle inventory level at the end of Q3 was "the lowest in over two years in terms of days of sales."

Reservation update

Tesla finally updated its reservation numbers, writing that "less than 20 percent" of the 455,000 net reservations reported in August 2017 have canceled. The company is expecting most of the remaining reservations "to gradually convert to orders as we launch more versions of Model 3, introduce other financing options, and begin sales outside North America."

The company announced a new "Mid Range" Model 3 earlier this month that comes with a shorter range and lower price. Musk expects to begin taking orders from Europe and China for the Model 3 by the end of this year.

And despite the tariffs on U.S. cars, China deliveries "still remained a material portion of our Q3 deliveries."

Solar power growth and energy storage triples

Revenue and profitability for Tesla's energy business are both improving. And based on today's bulletin, reports of SolarCity's death are an exaggeration.

The solar business installed 93 megawatts, mostly loans and cash sales, up 11 percent from the previous quarter's 84 megawatts. Wood Mackenzie Senior Solar Analyst Allison Mond calculates that Tesla installed 53 megawatts of residential solar in each of the first and second quarters of this year (Tesla no longer breaks out residential solar sales from commercial sales).

Energy storage installs grew to 239 megawatt-hours, up 18 percent from last quarter and more than double the same quarter last year. Tesla claims that it is on track to triple energy storage deployments year-over-year.

Tesla is increasing Powerwall production (and price) to deal with its backlog and is "prioritizing residential solar installations that are combined with energy storage products" to improve revenue, profits and the customer experience. Tesla asserts that selling through its stores and its automotive customer base "significantly" lowers its customer-acquisition costs.

Energy generation and storage revenue amounted to $399 million, slightly up from last quarter although at a much better margin of 17 percent. Historically, solar installations tend to decline in the fourth quarter across the industry.

Outlook and guidance

Musk expects Model 3 quarterly production and deliveries to "continue to increase in Q4 compared to Q3." Also, Tesla still plans to hit its goal of delivering 100,000 Model S and X vehicles this year. The company expects Model 3 margins to "remain stable," while gross margins for Model S and X "will likely decline slightly in Q4," due to tariffs on Chinese-sourced components.

Tesla reaffirmed its prior guidance "that we expect to again achieve positive GAAP net income in Q4. Similarly, in Q4, we continue to expect to generate positive cash from operating cash flows net of capital expenditures. Our cash position should remain at least flat in spite of our plan to repay $230 million of convertible notes in cash during Q4."

The company expects capex in next quarter to include buying land in China for Gigafactory 3 and the initial design of the plant.

This was a hugely important quarter for Tesla — and the company delivered the numbers. The stock is up 12 percent in after-hours trading. Tesla looks to continue to lower costs and increase production while driving down the price of the Model 3 to $35,000.

"Sufficient Model 3 profitability was critical to make our business sustainable — something many argued would be impossible to achieve," Musk said in a statement today. "Due to the ingenuity and incredible hard work of our team combined with an innovative vehicle design and manufacturing strategy, we have achieved total auto gross margin of ~25 percent."